Study on the Essence of Initial Public Offering Finance Essay

The essence of an initial public offering (IPOs) is simple - it is the first public sale of the shares of a company aimed at raising capital. Three main participants in the IPO process are (1) the issuing firm, (2) the investment bank underwriting the offering, (3) and the investors. Most companies have found a certain window of opportunity to take their shares public. This means that the market conditions and the anticipated valuation of the company are favorable at the time to take the stock to the public equity market. It is critical to prepare for that window, and understand how the IPO process works. Underwriting is the process through which investment banks raise capital from investors on behalf of the corporations that are issuing securities. This is a way of selling securities and bonds to investors. A syndicate of banks take on the risk of distributing these securities. This paper investigates the initial public offering process and underwriting process with examples of two Estonian IPO's - Arco Vara AS and Olympic Entertainment Group AS. The analysis tries to get an answer to the question of why these IPOs turned out to be so different from each other.

2. IPO Process

2.1. Directives and Regulations in EU

In European Economic area the financial market is regulated by four directives which are published by European Parliament and Council. These directives are: the Markets in Financial Instruments Directive (MiFID) the Prospectus Directive the Market Abuse Directive the Transparency Directive. The European law states that a Directive has to be transposed into national law. MiFID is considered to be the cornerstone of European Commission's Financial Services Action Plan. It covers almost all tradable financial products with the exception of certain foreign exchange derivatives and commodity, freight, climate, and carbon derivatives. The companies are authorized and regulated in the country where they have their registered office or head office. Once a firm has been authorized, it can use the MiFID passport to provide services to customers in other EU states. In addition, the firm must categorize clients as professional clients and retail clients, as retail clients have an increased level of protection. The categorization must be based on clear procedures. The companies must publish the prices, volumes and timing of all trades in listed shares, even if executed outside of a regulated market. The company is also responsible for taking all reasonable steps to provide the best execution for orders. The best possible result is not limited to execution price, but also includes cost, speed, likelihood of execution and settlement. The Prospectus Directive regulates access to the market by prescribing the principles for drafting a prospectus covering any offer of securities to the public. A single passport enables companies making an offer to use one prospectus throughout the entire European Union. It's made easier by the requirement of translating the prospectus to English. The Market Abuse Directive is ment to ensure the integrity of financial markets of Europe and to enhance investor confidence. It contains the general "framework" principles relating to market manipulation and insider dealing. It defines and prohibits both forms of market abuse and provides for a number of preventive measures such as the prompt disclosure of inside information, management transactions and safeguards regarding the impartiality of investment research. The Transparency Directive is meant to harmonize the provisions of national laws on periodic and ongoing requirements of information for issuers of securities to ensure a higher level of protection to investors throughout the European Union. The Transparency Directive requires listed companies to issue annual and half-yearly reports and quarterly management reports for only the first and third quarters. The persons responsible for these reports have to be noted in these.

2.2. Reasons for Going Public

A few reasons for why companies go public are (1) to rise capital to expand operations, (2) to increase liquidity of the company, (3) to increase stock capital, which can be used to make acquisitions, and also to compensate management and employees whether through higher salaries or in the form of stock options. The first reason is to raise capital for expansion into new territories or markets. Being public is associated with and demands credibility and accountability. The second reason would be the sale of the shares of the company as founders and the existing shareholders want to trade their shares for cash or other traded stocks (also referred to as "exit strategy"). The third possible reason could be the expansion of the company either by merger or acquisition. Getting more money into the company allows the company to finance takeovers or mergers with other companies. Also being public allows the company to merge with others who want to become public without going through an IPO process (referred to as "reverse merger").

2.2.1. Issues in Going Public

There are a number of issues that the issuer's management must cope with. One of the issues that may arise from an IPO is a conflict between management and current shareholders who may be wary of having their participations diluted and allowing new investors to acquire enough shares to gain power over the board of directors. In the case of single-tiered corporate governance structures, this refers to the board, while in two-tiered corporate governance structures this refers to the supervisory board. A second possible conflict may arise due to shareholders' perception that management and other insiders want to cash in their stock options as they have inside information that the IPO is overpriced or that the owner-managers of the entity want to embark on an exit strategy.

2.3. IPO Timeline

The actual IPO process takes about three to five months starting from the day the company decides to go public until it receives the proceeds from the offering. Financial consultants help with reporting issues and accounting throughout that period. They also keep the company from getting into trouble. For example, the financial statements must be prepared in accordance with generally accepted rules. This financial consultant or investment bank is also the one that is underwriting the offering, alongside with the other investment banks that form a syndicate. An example timetable of the processes of taking a company public can be seen in Appendix 1.

2.3.1. Preparation Phase

In preparation phase the lead manager analyses the company's strategy and business plan, after which the shares positioning is fixed i.e. the reason why an investor would be interested in buying shares. The most labor consuming part of this stage is the legal, financial and business audit in the company. The public offering prospectus is drawn up on the basis of the audits. In the preparation phase, the lead manager also arranges a preliminary share evaluation, using discounted cash flow analysis, comparative ratio and other valuation methods. During the "quiet period" There are certain things that the company's management can and can not say or publish. During this time, management is strictly bound to the information contained in the prospectus. Anything, including speeches, press releases, brochures, advertisements, talking to your neighbors about the offering, just about anything could be construed as releasing inappropriate information. After the "quiet period", the potential interest among institutional investors is ascertained. Possible problems related to the company's share positioning are pinned down in the course of the preliminary presentation. Possible share price ranges becomes clear from the feedback from professional investors. Meanwhile, in co-operation with the Financial Supervision Authority, which is responsible for supervising public offering registration a dialogue is established with the stock exchange. A marketing campaign is also prepared. Usually the duration of the preparation phase is two to four months, but it may take longer.

2.3.1.1. Registration Process

A carefully crafted Registration Statement is required to be prepared by accountants and lawyers. This requires detailed information about: Business product/service/markets; Risk Factors; Company Information; Officers and Directors; Audited financials; Proceeds Use (How are you going to use the money); Identification of your principal shareholders; Related party transactions. After the registration is made, it is submitted to the Securities and Exchange Commission and various other regulatory agencies for their detailed review. If this process is completed, the management presents a "road show" to the company's stock broker, who sells the stock to public investors. Then the proceeds should be invested wisely to enhance the value of the stock.

2.3.2. Offering

The public offering is registered with the Financial Supervision Authority and the offering is announced. There is usually no public discussion about the offering before the offering announcement, as there is no certainty that the offering will take place. This is followed by the subscription period, which usually lasts for 2 weeks. At the same time, the managing body of the company carries out a road-show, introducing the company's strategy, financial situation, competitive advantages etc. At the end of the subscription period, the lead manager collects the interests shown by retail investors' interests and the buy orders made by professional investors during the course of the directed offering in order to determine aggregate demand. Based on the full volume of demand and the prices offered by institutional investors, the company decides between a public and direct offering (in case this is not predetermined) and fixes the price. The issuer, selling shareholders and transaction lead manager sign an underwriting agreement, according to which the lead manager is obligated to guarantee cash to be received for the securities, if any investor should withdraw their interest to buy. The decision to use overallotment options is also taken. This is an agreement between the lead manager, selling shareholders and the issuer, whereby the lead manager is entitled to deliver more shares in the offering than originally planned (usually 10-15% of the planned transaction volume). The overallotment option is used in case the offering is oversubscribed. Within the following 3-5 days, the shares are transferred to investors' accounts and the share is listed on the securities' exchange market and trading begins.

2.3.3. Price Formation

By the moment the public offering is announced the issuer together with the lead manager have decided on the range of the final price. According to the book-building method, price is based on indications from professional investors, i.e. what price the professional investors are ready to pay and how much they are ready to buy. Estimating the given information (both price and amount) of aggregate demand of the offering and the number of investors participating in the demand (investing prospect and integrity), the company together with the lead manager determines an equilibrium price, for which all investors can buy the securities. Internationally, the book-spread method is the most widely used, because it takes investors' opinions on share price into consideration, helping to reduce price fluctuations on the direct secondary market. Alternatively one could use auction-based price formation, according to which the highest price at the auction determines the price. Such price formations have not been used in Estonia.

2.4. Underwriting

Underwriting was first practiced in the seventeenth century in connection with the shipping ventures. The leading ship merchants of London were used to get together in Lloyd's Coffee House to make their mutual business. In time, the custom to share the risk of venturesome voyages among various merchants was rising. Each of them agreed to stand for a fixed share of the loss or to obtain proportionate share of the profits. The agreement was passed around to each merchant, and who agreed wrote his name under the contract. That is where the term "underwriting" comes from. As is known, the term was primarily associated with the distribution of insurance risks, although when applied to the bond and securities issues, it also distributes the risk of failure. Therefore the essential idea is the same.

2.4.1. Importance of Underwriting

Importance to the Corporation

The advantages of this agreement to a company are well worth a large sum of money. After the issue has been underwritten, the issue is a sure success to the corporation. They may proceed to finance whatever project from the freshly raised capital. There is no annoying and costly waiting time when the securities are being sold. It is in a nature of many new businesses that time is an important factor for making them successful. For example, if a new factory being built in order to deal with certain contracts, or if efforts have been made in order to prevent competition, it can be fatal to the project when it was set up later after all the stock or bonds are sold. Second very important advantage is that the underwriter ensures success in raising the total amount of capital demanded. Frequently any amount less than the total amount would be a burden rather than strength to the corporation. Therefore it is the underwriters' concern to raise the capital and if they fail to do that then they have to pay up the difference from their own capital. Underwriting agreement carries with it the advantages that go into all the other arrangements, under which the banking house agrees to market the company's securities. The company will benefit from the specialized experience of the bank, and thus the risk of a serious error in the form or the price of new security is minimized.

Importance to the Investor

Not only does the company benefit from the underwriting agreement, but also the buyer has its advantages. First, the fact that the syndicate has been formed in first-class banking houses is essentially a guarantee that security is sound. Another advantage is the greater security of insurance against the buyer of the same events, which could harm the company because it must be remembered that at the time the buyer becomes the owner of a bond or a stockholder of the company, she begins to share his good or bad luck. If a corporation, therefore, has been damaged by dragging out the sale of a new security issue over a long period of time, or by bringing out the security issue, which ultimately is not completely disposed of, the buyer is one of the sufferers. It is, therefore, in his preference that the issue should be underwritten, and therefore ensured its success.

2.4.2. The Underwriting Syndicate

Originally the idea of underwriting consisted of risk sharing among several merchants. This remains the same for today's underwriting. It is true that the word is often implemented by agreement between the company and a bank, where the bank is willing to take over a block of securities at a fixed price. This type of transaction may be better to be called a sale - or a contract of sale - not the underwriting contracts. But such an arrangement where only one bank is involved, it is virtually unknown except to cover small size issues. Usually, however, the initial contract has been made between the company and one banking houses, and later the lead manager distributes the proportions of risk and profit between other banking houses. All of these houses, working together, thus form a syndicate. Most major banks and financial houses make these practices work in harmony with each other. There are two reasons that make it preferable for a lead manager to join a significant number of syndicates rather than put out a smaller number of transactions in which it would take all the risks and all the profits themselves. The first and obvious reason is to minimize risk. Wrong step in a syndicate will not be disastrous, but given the failure of good size issue if only one house was concerned, it might not only tie up enough capital to wreck the house, but it can also wreck your reputation, which might be an even greater asset to the banking house. Another motive to participation in a syndicate is that it allows the bonds and brokerage firms to offer their clients a well-diversified list of securities. General retail security merchant should be able to provide to the customer any securities that the customer may want.

2.4.2.1. Syndicate Agreements

There are four different types of agreements between the underwriting syndicate and the company. Possible other variations of these basic types could be found. The first is when the company can sell the issue themselves and the syndicate may simply be to ensure that the entire issue is sold in a certain period of time at a minimum price. For example, the company is to sell an issue of $1A 000A 000 6% bonds. Syndicates may agree that it would the bonds left unsold at the end of the year with a special price of $90. The underwriting syndicate receives a commission of 2-5% for making this agreement. If the issue can be successfully sold, the syndicate would collect and share their commission. If the issue was unsuccessful, the syndicate has to take over the unsold balance with the agreed price and dispose of it. This type of arrangement is now uncommon except in cases where the company has given its shareholders subscription privilege, but fearful that the offer is not taken away entirely. Second is where the banking house may enter into an agreement with the company to sell a block of securities and is allowed later to transfer them to other banking houses to share the risk and profit, by forming a syndicate. The Corporation, however, does not have dealings with a syndicate, as such, but only the original underwriter becomes the lead manager of a syndicate. The third type is when the syndicate may be formed before signing a definitive agreement with the company and the agreement may be directly between the company and the syndicate, although the management of the entire transaction and the actual sale of securities may be in the hands of one banking house, which has taken the initiative. This banking house carries out the sale of securities and does not distribute to the other members unless the sale is wholly or partially unsuccessful. The fourth type of agreement is between the underwriting syndicate and the issuing company. The securities are distributed to all of the members at the same time in proportion to their participation. Each banking house is expected to operate independently in selling of their proportion of the issue. This is probably the most common agreement type, and the most useful for handling large issues. It is clear from the above brief description that the term "underwriting" is used in different ways. This is in fact often difficult to see the difference between the actual underwriting of securities and just buying a block of securities. Even if the entire security issue is taken over by one bank and the agreed price is paid for this issue, it is still mostly referred to as "underwriting". Whatever the type of syndicate is, there is always a common feature: the leading management role is always in the hands of the banking house that organized the syndicate.

2.4.3. Community of Interest Among Underwriting Houses

When one of the investment banks gets a good agreement with an excellent opportunity of profit, others will usually be invited to be the members of the syndicate agreement. In this way, they are all more or less taking part in all significant underwritings. There are, of course, no formal agreement on this, but it is implicitly understood that if one allows another banking house to join a profitable issue, the benefit must be returned as soon as possible. This arrangement is well understood in many cases - at least in the Wall Street district, and probably also in other centers. The banking house which has made an agreement with a company will just distribute the shares as it considers best and shall notify each participant to create a syndicate. An important result of this "community of interest" arrangement is that it removes the time one of the leading banking houses in keen competition. This is a relatively small matter whether one house or another company has negotiated with a syndicate and becomes the active control, because in any case essential to take part in a syndicate of houses and a fair share of the profits. This "community of interest" arrangement has an impact to the competition. It removes the keen competition among the leading banking houses. Therefore it is not that important whether one or another banking house carries through the negotiations with the issuing corporation and becomes the lead manager of the syndicate, because in any case each of the important houses will participate in the syndicate and get a fair share of the profits.

2.5. Underpricing

Underpricing can be the positive average abnormal return from an IPO from buying stocks in the IPO and after they start trading in the secondary market selling them right away. Underpricing is the difference between the offer price and the first day's closing market price. It has been observed that underpricing is an almost universal feature of the IPO market. In the study by Loughran, Ritter, and Rydqvist (1994), the authors show that underpricing appears in almost all IPO markets in the world.

2.5.1. Why Underpricing?

There are a couple of reasons given why underwriters underprice IPOs. Generally, these reasons are not mutually exclusive. Underpricing two dominant theories are asymmetric information theory and signaling theory. Rock [1984], a pioneer in asymmetric information theory, suggests that the asymmetry in the IPO process itself causes underpricing. Famously coined as the "winner's curse" Rock proves that in order to gather interest of uninformed investors, the firm must offer a discount to the price of shares. Signaling theory proposed by Allen and Faulhaber [1989], implies that high quality firms underprice their shares raise the quality of their company. This theory reasons that the companies are optimistic about the future and want to leave "a good taste in the mouth" for investors so if they decide to do a secondary offering the investors will act through their good memories from the first offering. This theory was confirmed experimentally by Jagadeesh, Weinstein and Welch [1993] when they showed a positive link between the cost of the IPO and secondary offerings. Therefore means that in order to ensure a successful future deals, companies and underwriters underprice the IPO.

3. Analysis

3.1. Definitions

3.1.1. Liquidity Analysis

The Current Ratio, defined as current assets divided by current liabilities, has been used as measure of liquidity. Many analysts acknowledge that, if the ratio value remains below 1, it may indicate that the company has or will have liquidity problems in the upcoming periods.

3.1.2. Leverage Analysis

The Equity Ratio is an indicator of the degree of financial leveraging i.e. the relationship between equity and assets. If the equity to asset ratio is 60%, then the liabilities to equity will equal 40%.

3.1.3. Profitability Analysis

Return on assets (ROA) is a measurement that shows the relationship between average assets and profits. Return on equity (Equasion 3.1) shows the amount of net income returned as a percentage of shareholders' equity. The increase in equity ratio is expected to produce good results for shareholders of the company as long as the company earns a rate of return on assets that is higher than the interest rate paid to creditors. Equasion 3.1: Return on Equity (ROE) Gross Profit Margin shows the relationship between cost of goods sold and net sales revenue. A high gross profit margin indicates that a business can make a reasonable profit on sales, as long as it keeps overhead costs in control. Net Profit Margin shows how much profit a company makes after financing costs and taxes.

3.2. Overview of Tallinn Stock Exchange

The only regulated securities market in Estonia is the NASDAQ OMX Tallinn. A common electronic trading system allows the listed companies to gain access to a host of capital resources and also exchange's members, mediating securities transactions of the investors. INET and SAXESS trading systems of OMX Nordic Exchange are used in NASDAQ OMX Tallinn. As of May 2005, these systems are also used in Latvia, Lithuania, Finland, Sweden, Denmark, and in Norway. The electronic Estonian central securities register and pension fund register is administered by the Estonian CSD. They concern with the payment of dividends and interest, arranging of shareholders' general meetings and provides various services related to securities. The Estonian CSD also keeps the register of all public limited liability companies operating in Estonia, numerous private limited companies, funds and companies' debt obligations. The register includes all Estonian private and legal persons' securities accounts.

3.2.1. Economic Situation

The factor that had the most influence on the financial results of NASDAQ OMX Tallinn Group on the year 2008 was the slow-down in trading activities and falling share prices, caused by the downturn in the international financial markets. "The operating revenue of the NASDAQ OMX Tallinn Group (together with the Estonian CSD) decreased by 7.8% to EEK 65 million in 2008 (in 2007, EEK 70.5 million), while the operating revenue of the NASDAQ OMX Tallinn Stock Exchange amounted to EEK 22.3 million (in 2007, EEK 27.4 million). The equity capital of the Group was EEK 83 million at the end of the period (in 2007, EEK 85 million) and the consolidated net profit for 2008 amounted to EEK 20.4 million (in 2007, EEK 28.9 million)." (NASDAQ OMX Tallinn Group, 2009) As seen from Appendix 2, the OMX Tallinn index has been falling since the fourth quarter of year 2007. At the end of 2008 the index had fallen about 70% from the end of 2007 and is moving closer to the value level it had in the beginning of 2000's.

3.3. Overview of Companies

3.3.1. Arco Vara AS

Arco Vara group is a real estate developer and agent in Baltic countries. It is undergoing a CEE (Central and Eastern Europe) expansion and is already present in Bulgaria, Romania and Ukraine. Their main activities are property development, consulting, investment management, civil and environmental engineering. For the first time the company sold their shares to the public on 21 June in 2007. The company was founded in 1992 as a real estate agency. In 1996, the first development project was launched in Tallinn and next year they expanded into Latvia. Currently, Arco Vara group is based in five countries with 20 offices in Estonia, Latvia, Lithuania, Bulgaria and Ukraine. The Group employs over 400 people. Their revenues and change of revenues can be seen from Figure 1. Arco Vara group's activities can be divided into three divisions: construction division; development division; services division. Services Division of Arco Vara group is located in all countries they operate in. Services offered include brokerage of real estate, appraisal services, real estate consultancy, property management and comprehensive real estate consulting services. In addition, the services division is engaged in the management of the two real estate portfolio. Development Division of Arco Vara group is experienced in the development of residential and commercial areas. Projects include apartment buildings, semi-detached houses, private houses, land and multi-functional commercial spaces. Development process involves many areas and their core competence lies in the ability to manage the whole property development process from beginning to end. Construction Division of Arco Vara Group is engaged in general contracting, construction and environmental construction. Over 40 years experience in the field, the main objective is to achieve a state of division with the highest quality and most environmentally friendly company, offering integrated solutions in consultation with the planning and design for both commercial and residential customers. Figure 1: Revenue, Revenue growth and Net Profit for Arco Vara AS Source: Annual reports, calculations based on annual reports

3.3.2. Olympic Entertainment Group AS

Olympic Entertainment Group is the largest casino entertainment company in the Baltic States and one of the most rapidly developing companies in Eastern Europe. Olympic Entertainment Group AS is the ultimate holding company of the group, through what the strategic management and financing is being done. Local casinos are operated by local entities, including the Olympic Casino Estonia AS in Estonia, Olympic Casino Latvia SIA in Baltic Gaming AS Latvia, and the Olympic Casino Group Baltija UAB in Lithuania, Olympic Casino Ukraine TOB in Ukraine, and Olympic Casino Bel IP in Belarus. In Estonia, Latvia and Lithuania, the non-core operations, such as bars are separated from casinos operations and are managed by specialized entities. The company sold their shares to the public for the first time on 23 October in 2006. The Organization's work in Estonia, Latvia and Lithuania are certified according to ISO 9001 international quality requirements. The Revenues of Olympic Entertainment Group can be seen from Figure 2. Figure 2: Revenue, Revenue growth and Net Profit for OEG AS Source: Annual reports, calculations based on annual reports

3.4. Analysis of Public Offerings

3.4.1. Arco Vara AS

Lead manager for the IPO of Arco Vara was Skandinaviska Enskilda Banken AB's London Branch and AS SEB Enskilda was jointly the "manager". According to the Emission Prospectus, Arco Vara's IPO size was 34A 450A 000 ordinary shares, net proceeds from were expected to be approximately EEK 1A 372 million, and the total cost of listing was approximately EEK 66 million. Arco Vara was planning to invest the net proceeds from the IPO in new real estate projects and development mostly in Bulgaria, Romania, and Ukraine. In addition, it is planning to develop already existing housing and business real estate in Estonia and Latvia. In the prospectus, it was said that some of the proceeds might be used for the development and growth of other sectors of the company, to pay back preexisting debt, or for other general business purposes. Financial statement information for Arco Vara is in Appendix 3. According to the Current Ratio, Arco Vara was not in a good position before the IPO having a low, below 1, ratio. Quick Ratio (also known as the Acid-Test Ratio) is fluctuating from 0.2 to 0.5 at different years before the IPO and shows very bad liquidity to the company. Equity Ratio indicates the leverage to investment in operations. Leverage is defined as borrowed capital. Arco Vara had a ratio of 39.7% in 2005 and 32.1% in 2006, which can be seen from the Table 1 also. After IPO, equity capital from all of the assets was 53.4% for Arco Vara. Arco Vara had a low Return on Assets (ROA) before going public. Their ROA for 3 years before going public was at range from 8.5% to 11.7%. After IPO the ROA for Arco Vara was 7.5% and the next year, 2008, it was -38.3%. Return on Equity (ROE) shows the amount of net income returned as a percentage of shareholders equity. Arco Vara's ROE for the years before IPO were 26.9% and 31.5%. After IPO the ROE for Arvo Vara was 14.2% for 2007 and -74.5% for 2008. Revenue growth had a little slowdown in 2006 right before the IPO, but the year of the public offering they had a 50% growth of revenues. In 2008 they had a negative growth of -9.3% caused by the cooling down of the real-estate market. Gross Profit Margin indicates the relationship between net sales revenue and the cost of goods sold. A high Gross Profit Margin indicates that a business can make a reasonable profit on sales, as long as it keeps overhead costs in control. Arco Vara's Gross Profit Margin was 24.7% in 2005 and 27.8% in 2006. After IPO the margin stayed almost the same in 2007 but the next year, in 2008, it fell -53.2%. Net Profit Margin shows how much profit a company makes from investing into its operations. In 2005 and 2006 Arco Vara had Net Profit Margins 24.5% and 44.9% respectively. After the IPO it was 32.4% in 2007 and -175.8% in 2008. Their Net Profit Margin is very sensitive to the changes in the economy and in the demand of real-estate. It is also reflected in the Net Profit Margin of 2008. Table 1: Financial Ratios of Arco Vara 2005 2006 IPO - 2007 2008 Equity Ratio 0.39 0.32 0.52 0.36 ROA 9% 12% 8% -38% ROE 27% 32% 14% -75% Revenue Growth 36% 2% 50% -9% Gross Profit Margin 25% 28% 25% -53% Net Profit Margin 24% 45% 32% -176% Source: Annual reports, calculations based on data from annual reports In Figure 3, the price movement of Arco Vara's stock is shown. As can be seen the price started falling right away after the IPO. One reason for Arco Vara's stock price fall might have been the poor work of underwriters as market makers. Underwriters were supposed to create trades and manipulate the market for the price to go up in the beginning. Arco Vara did not have that classical IPO where at first the price would rise for some time, also creating a possibility for exit strategy, and after the market makers have stopped, the price would start to fall. Figure 3: Arco Vara stock prices and volume of trade Source: NASDAQ OMX Baltic

3.4.2. Olympic Entertainment Group AS

Lead manager for the IPO of Olympic Entertainment Group was Hansapank with a co-lead manager LHV Financial Advisory Services. IPO's size was 14A 000A 000 ordinary shares, where net proceeds were expected to be approximately EEK 1A 038 million, and the cost of listing approximately EEK 24 million. The primary purpose of the Offering is to attract additional capital to finance the further expansion of the group in Estonia, Latvia, Lithuania, Ukraine, Belarus, Poland and other Central-Eastern European countries. Such additional capital will allow the Group to maintain its strategy of aggressive geographic expansion and facilitate the opening of new casinos in the existing and new markets as well as the acquisition of other operators or their existing casinos. Financial statement information for Olympic Entertainment Group is in Appendix 4. Olympic Entertainment Group had a high equity ratio already before the IPO. It was 63.1%. After the IPO it was 89.8%. Return on assets pre-IPO were 28.5%, which showed a slight upwards movement, although it was relatively high already. After the IPO, return on assets decreased to 24.8%. Before IPO the return on equity was 42.2% and post-IPO it was 30%. Revenues were also growing at a high rate - 41.6% in 2005. As seen from the Table 2, net profit margin and other margins rose before public offering, which made the IPO even more promising. The asset base of the company almost doubled from 2004 to 2005. Considering all the facts presented in the prospectus and the financial statements for prior years, the IPO looked promising. As can be seen from Figure 4, it was successful investment during the six months after the IPO, with stock prices rising from EEK 90 to almost EEK 180. A possible explanation for this movement of the stock is the lock-up period lasting about 6 months, after what some of the owners and underwriters might have sold a large amount of stock. Table 2: Financial Ratios of Olympic Entertainment Group 2004 2005 IPO - 2006 2007 Equity Ratio 0.75 0.63 0.89 0.86 ROA 25% 29% 25% 15% ROE 33% 42% 30% 17% Revenue Growth 33% 42% 90% 51% Gross Profit Margin 62% 64% 62% 61% Net Profit Margin 21% 24% 24% 15% Source: Annual reports, calculations based on data from annual reports Figure 4: Olympic Entertainment Group stock prices and volume of trade Source: NASDAQ OMX Baltic

4. Conclusion

From the analysis of the prospectuses the author concludes that the motives to go public were similar for both of the companies. They were planning to use the proceeds to invest to widen their market share behind the borders and to geographically expand. Financial data did not show good signs for Arco Vara because firstly the company did not have enough liquidity in their assets. Also the equity ratio was too low being before the IPO only 32%. In the profitability analysis the return on assets was low being in the range of 8.5% to 11.7% before the IPO. On the other hand the gross profit margin and net profit margin were fairly high. Olympic Entertainment Group had much better financial data before the IPO. Before the IPO they already had a high equity ratio, good return on asset and the return on equity ratio. Also the profit margins were fair. These were two very different initial public offerings. Arco Vara started to fall right from the beginning and did not have that classical IPO slope where it rises in the beginning for some time and then starts to fall when the underwriters have finished their job. Then again Olympic Entertainment Group rose for a few months before it started to fall. Then the question was why did Arco Vara had worse IPO than Olympic Entertainment Group. Arco Vara's public offering cost them almost three times than it did to Olympic Entertainment Group. The reason why Arco Vara's IPO was not very successful was the cooling down of the real estate market and the economy in general. The timing of the IPO was bad. It can be seen from Appendix 5 that the prices of other real estate and construction companies' share started falling even some time before the IPO of Arco Vara. And right at the time of their IPO, the OMX Tallinn index started to fall also. Therefore in conclusion we can say that the underwriters can't always push the price of the share up. There are other factors that might make it almost impossible, for example the timing of the IPO. The example of Arco Vara showed that they did not have that "window of opportunity" at the time. At least the general economic situation did not favor them.

References

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Resümee

Appendices

Appendix 1. IPO Process Timeline Example

Time Period

Process

1st Day Initial organization meeting and due dilligence; Review Timetable; Review letter of intent and discuss underwriting issues; Discuss Underwriters' fees and compensation; Assign registration statement preparation responsibilities; Identify accounting and other problems; Select Printer; Review financial forecasts; Management due dilligence presentations; Discuss transfer agent and registrar; Prepare list of parties involved (phone numbers, addresses, secretaries, etc.) referred to as the working group list. 14th Day First draft of registration statement distributed. 21st Day First drafting session and due dilligence: Complete due dilligence presentations; Review draft of registration statement; Discuss problems. 21st to 22nd Day Revise registration statement; underwriters' counsel to draft and distribute underwriter's agreement, agreement among other underwriters, selling agreement and other documents relating to underwriting ("underwriting document") to company counsel. 27nd Day Distribution of second draft of registration statement. 31st to 32nd Day Second drafting session to review registration statement. 32nd to 46th Day Questionnaires completed by officers, directors, and 10% shareholders and returned to company counsel for review. 33rd Day Distribution of third draft of registration statement. 33rd Day Distribution of mangement's discussion and analysis of financial position and results of operations.

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